Equity Incentive Plans for Startups – An Overview
By Kate Ballard
If you’re in the startup community, there is a good chance you have heard of equity incentive plans, also known as stock option plans. So what exactly is an equity incentive plan? An equity incentive plan is a structure that allows a company to award equity incentive compensation to its service providers such as employees, advisors, directors, and consultants.
Two primary objectives of equity incentive compensation are: (1) to incentivize recipients to build company value by allowing the recipients to benefit from the company’s growth in value; and (2) to align the interests of the compensation recipient with that of the company’s.
While it is possible for companies to award equity incentive compensation without using an equity incentive plan, a well drafted plan greatly reduces administrative burdens and streamlines the process for each individual grant of equity compensation.
The purpose of this blog post is to provide an overview of some of the most important components of equity incentive plans, including the common types of awards granted, the timing provisions associated with the awards, and the typical share pool size of equity incentive plans.
Structure of Equity Incentive Plans
A variety of equity incentive awards can be issued under a company’s equity incentive plan. Equity incentive compensation generally falls into two buckets: (1) The actual grant of ownership stake in the company and (2) The grant of an award that is pegged to the valuation of the company.
Grant of Actual Ownership Stake – Options and Restricted Stock Awards
Stock options and restricted stock awards are the most common types of awards granted under equity incentive plans. For these types of awards, the company grants the opportunity to own actual shares of the company.
Options are the most common type of equity incentive compensation awarded under equity incentive plans. That is why equity incentive plans are also known as “stock option plans.” However, this is a bit of a misnomer because companies can issue equity compensation other than options under an equity incentive plan.
Most simply put, a stock option is the right to buy a company’s stock at a predetermined price, called the exercise or strike price. The exercise price is typically equal to the fair market value of the underlying stock at the time the option is granted. There are adverse tax consequences if the exercise price is set below the fair market value of the underlying stock on the date of grant, but that is beyond the scope of this blog post.
There are two types of options: (1) incentive stock options (“ISOs”) and (2) non-qualified stock options (“NQSOs”). ISOs are strictly awarded to employees only and enjoy certain tax-favorable treatment. NQSOs, on the other hand, can be awarded to service providers other than employees, but do not benefit from ISOs’ tax-favorable treatment. We will discuss the difference between ISOs and NQSOs in more detail in an upcoming blog post.
- Restricted Stocks Awards
Unlike options which grant the right to purchase a company’s stock, a restricted stock award (“RSA”) is the outright grant of the company’s shares. Once a company awards an RSA to a service provider, he or she immediately becomes the beneficial owner of the company’s shares and is entitled to voting rights, dividends, and other shareholder rights (subject to the unique restrictions for a given RSA).
RSAs are “restricted” because they are subject to restrictions until some future date. One common restriction is the company’s right to repurchase the awarded shares. Another common restriction is that the RSAs are subject to forfeiture by the holder should the holder leave the company before a certain date.
Other Awards Pegged to the Company’s Valuation
Recall that the primary purposes of awarding equity incentive compensation include incentivizing recipients to build company value, thereby aligning the recipient’s interests with the company’s interests. These goals can also be accomplished without granting options or RSAs. Instead, other awards whose values are tied to the company’s valuation can accomplish the same goals.
These awards include restricted stock units, phantom stock, and stock appreciation rights. Restricted stock units and stock appreciation rights are a sort of hybrid between awards granting the right to actually own a company’s stock and awards pegged to a company’s valuation. Whether it is one or the other will depend on how the particular award is settled, discussed in more detail below.
- Restricted Stock Units
Restricted stock units (“RSUs”) are an unsecured and unfunded promise for a right to receive a share of the company’s stock in the future. Unlike an RSA, shares are not actually issued on the grant date so the RSU holder is not entitled to rights such as voting and dividend rights. RSUs may be settled via delivery of shares or in cash equivalent to the value of the company’s stock. If an RSU is settled in shares, then it is akin to an RSA; although the recipient does not become the beneficial owner until the settlement date.
RSUs are highly tax driven and are generally more suitable for later stage companies.
- Phantom Stock
Phantom stocks are essentially RSUs that can only be settled in cash. While one can award phantom stocks under equity incentive plans, most companies grant phantom stocks under a separate phantom stock plan.
- Stock Appreciation Rights
Stock appreciation rights entitle the recipient to the appreciation in value underlying shares. Stock appreciation rights are most commonly settled in cash, though they could also be settled in stock, or a combination of the two. A stock appreciation right settled in stock is identical to an option.
The type of award that makes the most sense will depend on the unique circumstances of the company and the intended award recipient. Early-stage startups typically use options and RSAs as they are simpler to administer. As a company matures, it may introduce other types of awards involving more complex administrative, tax, accounting, and corporate governance hurdles than options and RSAs.
Timing – Vesting
The awards granted under an equity incentive plan are typically subject to timing requirements called a vesting period in which the compensation vests over time. In other words, award recipients must wait until certain timing and/or performance goals are met. After all, this type of compensation is an incentive award so there needs to be restrictions to incentivize service providers to stay with the company, contribute to the company’s success, and see through the company’s appreciation in value.
An example of vesting will be illustrative: A common vesting schedule for stock options is monthly over four years with a one-year cliff. This means a service provider must stay with the company for one year before any of his or her options are vested. At the one-year mark, the service provider will have the option to purchase ¼ of the underlying stock at the predetermined exercise price. Thereafter, the remainder of the option award will vest pro rata every month for the rest of the three years.
Share Pool Subject to the Equity Incentive Plan
A company creating an equity incentive plan will need to decide how many shares will be designated for its equity incentive plan.
The size of a company’s share or option pool is generally somewhere between 5% to 20% of the company’s fully diluted capitalization. The lower end of the range is more common for later stage companies.
Equity Incentive Plans: A Valuable Tool
Equity incentive compensation can be especially beneficial to service providers working at nascent companies with a lot of growth ahead. By gaining early access to a company’s equity, service providers should stand to benefit from the company’s long-term appreciation in value because they are invited to take stake in the company when the company’s valuation is relatively low as compared to later in the company’s life-cycle.
At the other end of this, equity incentive awards can be particularly helpful for early-stage startups that may not have an abundance of cash to pay top salaries and bonuses to attract and retain the talent it needs to grow. Moreover, for startups that want to attract investments, equity incentive plans serve as a signal to potential investors that sufficient equity is reserved to attract and retain a quality workforce.